I spotted an interesting article last week, entitled "Here's the income portfolio you want to own when interest rates rise." Written by Mark Hulbert, it's addressing the question on everyone's mind these days. We were in the thick of our March issue writing when it came out, but I wanted to circle back to it later and unpack a few key points.
First, the good. Hulbert does a great job of illustrating an oft-overlooked point about rising interest rates and bonds. That is, while higher interest rates cause an initial loss of bond principle, they also allow for reinvestment in newly issued bonds that carry the higher yields. Hulbert cites a study that appeared in the Financial Analysts Journal last year as saying that for constant-maturity bond portfolios, "the greater yield earned during a rising-rate environment offsets the declining bond prices those rates cause."
In other words, if you're using a bond vehicle that typically keeps its maturities roughly the same, the higher yield income is going to roughly balance out the losses caused by the rising interest rates. Now, not all bond funds keep the same rough maturity target. But many do — for example, the short- and intermediate-term Vanguard index funds would be examples of funds that use a rough constant maturity approach.
Of course, you'd need to hold on for the course of several years, letting the cycle play out, before the higher yields have a chance to offset the initial losses. But the point is sound that higher interest rates don't necessarily mean holding bonds is a bad idea, even though you know there are going to be some lumps taken at the outset.
So far, so good. Here's the problem: Hulbert uses the infamous 1965-1982 period to illustrate this point and it doesn't really hold up.
During that period, Treasury yields almost tripled. Hulbert shows that "a portfolio of intermediate-term Treasuries, constructed to have a constant maturity of five years, gained 5.8% annualized from 1965 through 1982." He then states that return was almost as good as the S&P 500's 5.9% annualized return over the same period.
For starters, the 5.8% return for the bond portfolio does illustrate the principle we talked about initially. The 5-year Treasury yield started at around 5%, and ultimately the portfolio returned about that same level over the course of the rising rate period, despite the principle losses from the higher rates.
But don't mistake that for being a "good" return. The reality is inflation soared over 206% during that period, while the total gain of that bond portfolio was just under 176%. So yeah, the rate of return held up, but inflation meant a bond investor was actually losing ground little by little over that entire period.
The principle is sound: bond returns can hold up to rising rates. The problem is that what often has pushed rates higher in the past — inflation — isn't accounted for in that equation. If this were to happen in a period when inflation isn't rising (i.e., now), great. But that hasn't been the normal course of events in the past.
But the real "ugh" — comparing that bond performance to stocks, as if to make the point that bonds held up just as well as stocks during that period. I don't know if Hulbert was intending to steer readers to the conclusion that bonds may be just as good as stocks in a rising rate environment by that comparison, but it's an inaccurate conclusion, and a potentially dangerous one. First of all, that 1965-1982 period is often held out as one of the very worst sustained periods for stocks of the past century. So it's a tenuous period to be drawing conclusions from. But more importantly, the S&P 500 (which measures the very largest companies) performed much worse than smaller-company stocks. Small-caps returned double the rate of large-caps, meaning a diversified stock portfolio containing both small and large company stocks would have beat inflation during this extended period when bonds lagged it. That's a pretty significant point.
The main take-away from the article is sound though: "In other words, investors are not being irrational when they both expect interest rates to rise and they continue to allocate a chunk of their portfolios to bonds." In SMI parlance, if you're investing some of your money in bond funds like the short- and intermediate-term Vanguard bond index funds that SMI has long used, you're likely to come out just fine even if interest rates rise. Of course, our hope is that regardless of the interest rate environment, the bond upgrading portion of our portfolios will help position us in the most helpful (or at times, least harmful) portions of the bond market. Combining the two approaches (a static base with an Upgrading component) as our Upgrading bond portfolios now do should give us at least a fighting chance even if interest rates start heading higher in the months/years ahead.